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The jury is still out on the need for capital markets-based reinsurance products, but several interested companies in Bermuda are betting on a favorable verdict.

Two investment banks this year set up reinsurance operations in Bermuda that will focus on securitization of risks. The Bermuda Commodities Exchange commenced operations last year and conducted its first significant transaction earlier this month. The Bermuda government enacted legislation this year to attract more securitization business. And one of Bermuda's largest reinsurers bought significant retrocessional coverage in a capital markets deal earlier this month.

The flurry of activity in Bermuda could develop into a new arm of the reinsurance industry in Bermuda, said Don Watson, a director at Standard & Poor's Corp. in New York.

The involvement of the investment banks in particular could help develop the sector, he said.

"They are experts at selling capital markets products, so when they get the insurance products structured, they will be able to go to the market and sell them," Mr. Watson said.

So far, few actual deals appear to have been done in Bermuda, but several of the companies there are working on potentially interesting and attractive transactions, he said.

For example, capital markets-based insurance contracts are being considered for utility companies that would finance the risk of a warm winter curbing demand for power and reducing their revenues, Mr. Watson said.

"It will allow them to have more predictable earnings," he said.

One of the investment banks that has set up a Bermuda unit is Lehman Bros. Holdings Inc., which established Lehman Re Ltd. in June with $500 million in capital.

Lehman Re will offer capital markets-based products as well as write reinsurance in a conventional way and then retrocessionally reinsure it into the capital markets, said Michael Gelband, head of fixed income derivatives at Lehman Bros. in New York.

So far, Lehman Re has only been involved in a few deals, but the potential for capital-markets based coverage is significant, he said.

"The market is only soft by conventional reinsurance standards. It could get even softer, but we don't think that that is a problem for us," Mr. Gelband said.

Once the market is established, capital markets investors may take on risks at lower rates than reinsurers are prepared to consider, he said.

Capital markets investors are looking for a spread of risk outside of their other investments and would not be so severely affected as a conventional reinsurer in the event of a large reinsurance loss, Mr. Gelband said.

So far, Lehman Re has focussed on property catastrophe business, but it also plans to write life and annuity coverage, political risk insurance, and finite risk coverage, he said.

In April, Goldman Sachs Group L.P. set up Arrow Reinsurance Co. Ltd. to transfer reinsurance risks to the capital markets by issuing securities or entering into derivatives contracts. Executives at Arrow Re would not comment on the progress of the company.

Bermuda's regulators are hoping to attract more securitization deals to the island.

Earlier this year, the Bermuda government amended its insurance regulations to enable investment in insurance derivatives without investors registering as insurers. Regulators believe that before the amendments took effect, Bermuda lost several insurance securitization deals to other domiciles, as it was not clear whether investors in the vehicles had to register as insurers in Bermuda (BI, March 30).

The Bermuda Commodities Exchange also is trying to bring capital markets deals to Bermuda.

The BCE was set up in October last year with 20 member companies drawn from financial services and reinsurance, including several of the Bermuda catastrophe reinsurers.

So far, there has been significant interest in the BCE, and a significant number of contracts have been offered, but no major programs have been covered, said Thomas C. Heise, president of the BCE.

However, earlier this month the first sizable contracts were traded on the exchange when two contracts offering $5 million each in limits for catastrophe coverage in the southeastern United States were traded.

Several of the catastrophe reinsurers in Bermuda also are showing an interest in capital markets-based coverage.

Most prominently, X.L. Mid Ocean Reinsurance Co. Ltd. bought about $200 million of retrocessional reinsurance in a deal placed with alternative market reinsurers and capital markets investors (BI, Aug. 17).

But it is still too early to tell whether the capital markets will be as quick to jump in if there is a significant catastrophe that causes a hardening in the reinsurance market, said Henry C.V. Keeling, president and chief executive officer of X.L. Mid Ocean.

"It's all very well for people to offer large amounts of capacity now with bonds and swaps, but we don't know how the market will react in the event of a loss, because it hasn't been tested," he said.

The capital markets may not react as speedily as traditional reinsurers if there is a large loss, said Alan Murray at Moody's Investors Services Inc. in New York. While the capital markets-based reinsurers could write the business quickly, they may face difficulties in laying off a complex blend of, say, Pacific earthquake and southeast United States hurricane risks to the derivative market, Mr. Murray said.

"That could be time-consuming," he said.

Talk about capital markets products still outweighs action, but the future of the sector will be clearer once the market suffers a large loss, said James P. Bryce, senior vp at International Property Catastrophe Reinsurance Co. Ltd.

"They have not had a major impact yet, but it is an interesting development. If there is a major market loss, it could be even more interesting," he said.

Both IPC Re and X.L. Mid Ocean are members of the BCE.

LaSalle Re Ltd. also is interested in developing capital markets expertise, said president and chief operating officer Guy D. Hengesbaugh.

"There is much more talk than action, but we have aligned ourselves in order to take advantage of gaps in the market," he said.

LaSalle Re has hired a capital markets specialist, and it will likely both buy capital markets-based coverage and offer capital markets products, Mr. Hengesbaugh said.